This report on Banking Union and bank reform in the EU, “Europe’s banking trilemma” [click to download], concludes that, despite its intention, Banking Union will fail to prevent European citizens from bearing the losses of failed banks in the event of a systemic banking crisis unless there are meaningful structural and capital reforms to Europe’s largest banks.

Bank deposits and payment systems are the lifeblood of our economies. Society relies on bank credit for economic and social order and governments will always step in to protect it.

The expectation of bail-out means that banks receive a funding subsidy via government guarantees.

There is no reason to subsidise trading activities, in fact this increases systemic risk.

In the last 25 years, our largest banks have evolved into “flow monsters” with balance sheets dominated by subsidised trading assets and inter-connected via the derivatives markets.

In today’s environment, it is difficult for highly inter-connected banks to undergo “creditor bail-in” without spreading danger throughout the financial system, which undermines the credibility of the bail-in mechanisms proposed.

The proposed Resolution Fund and the European Stability Mechanism are too small to withstand a systemic banking crisis on their own.

The activities that make banks too-big, too-complex and too-connected-to-fail also make them too-big, too-complex and too-connected-to-resolve in the normal way.

When resolution mechanisms are not credible, investors charge a lower risk premium, encouraging the very activities that make resolution difficult.

Without structural reforms and credible loss-absorbency mechanisms on banks’ liabilities, Banking Union risks becoming a paper tiger: a mechanism that appears to help but which delays meaningful bank reform and lacks teeth when the next systemic crisis strikes.

Policy recommendations in the report include:

A strong legislative proposal in the current European Commission mandate to separate commercial banking from investment banking and trading activities, including market making, as recommended by the High-level Expert Group led by Erkki Liikanen.

Significantly higher loss-absorbing capacity for banks, including equity requirements through the adoption of strict leverage caps by 2015.

Stronger powers for supervisors to intervene to ensure that recovery and resolution plans are realistic.